When you decide to start a business, one of your first questions is likely to be how to raise money to finance your business operations. No matter how you plan to obtain financing for your business, you need to spend some time developing a business plan.
Equity Financing
You may have some cash you want to put into the business yourself, so that will be your initial base. Maybe you also have family or friends who are interested in your business idea and they would like to invest in your business. That may sound good on the surface to you, but even if this is the best arrangement for you, there are factors you must consider before you jump in. If you decide to accept investments from family and friends, you will be using a form of financing called equity financing.
One thing that you want to be clear about is whether your family and friends want to invest in your business or loan you some money for your business. That is a crucial distinction. If they want to invest, then they are offering you equity financing. If they want to loan you money for your business, then that is quite different and is actually considered debt financing.
Advantages of Equity Financing
Disadvantages of Equity Financing
Remember that your investors will actually own a piece of your business; how large that piece is depends on how much money they invest. You probably will not want to give up control of your business, so you have to be aware of that when you agree to take on investors. Investors do expect a share of the profits where, if you obtain debt financing, banks or individuals only expect their loans repaid. If you do not make a profit during the first years of your business, then investors don’t expect to be paid and you don’t have the monkey on your back of paying back loans.
Since your investors own a piece of your business, you are expected to act in their best interests as well as your own, or you could open yourself up to a lawsuit. In some cases, if you make your firm’s securities available to just a few investors, you may not have to get into a lot of paperwork, but if you open yourself up to wide public trading, the paperwork may overwhelm you. If your business is in the USA, you will need to check with the Securities and Exchange Commission to see the requirements before you make decisions on how widely you want to open up your business for investment.
Debt Financing
If you decide that you do not want to take on investors and want total control of the business yourself, you may want to pursue debt financing in order to start up your business. You will probably try to tap your own sources of funds first by using personal loans, home equity loans, and even credit cards. Perhaps family or friends would be willing to loan you the necessary funds at lower interest rates and better repayment terms. Applying for a business loan is another option.
Advantages of Debt Financing
Disadvantages of Debt Financing
Any time you use debt financing, you are running the risk of bankruptcy. The more debt financing you use, the higher the risk of bankruptcy. Calculate the debt to equity ratio to determine how much debt your firm is in compared to its equity.
Some will tell you that if you incorporate your business, your personal assets are safe. Don’t be so sure of this. Even if you incorporate, most financial institutions will still require a new business to pledge business or personal assets as collateral for your business loans. You can still lose your personal assets.
Which is best; debt or equity financing?
It depends on the situation. Your financial capital, potential investors, credit standing, business plan, tax situation, the tax situation of your investors, and the type of business you plan to start all have an impact on that decision. The mix of debt and equity financing that you use will determine your cost of capital for your business.
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